The Stages Of A Forex Trend

A trend is simply a tendency for prices to move in a particular direction over a period of time. Trends can be long term, short term, upward, downward, and even sideways. When investing in the forex market, your success is tied to your ability to identify trends and position yourself for profitable entry and exit points. Let's look at some stages of a forex trend and how they affect investors. (For related reading, see Anticipate Trends To Find Profits.) TUTORIAL: Technical Analysis & Technical Indicators

Economic Trends Reflected in Currencies
For the most part, an economy that is strong will also have a strong currency. Economic strength attracts investment, and investment creates demand for a currency. In recent times, the demand for gold as an alternative to fiat currencies has led to a currency demand in those countries that produce gold, such as Australia, South Africa and Canada. (For more, see How To Trade Currency And Commodity Correlations.)

Example of a Trend in the Australian Dollar Against the U.S. Dollar
Note how the economic factors, in this case a demand for gold and the higher interest rates in Australia, have created a demand for the Australian currency. The demand will last until the exchange rate becomes too high and negatively affects Australian exports. In addition, factors in other economies have to be taken into account, since no single currency can act in isolation of the rest of the world's economies.

The chart below (Figure 1) of the weekly AUD/USD shows the recent upward exchange rate trend in the Australian dollar against the U.S. dollar. While the price (exchange rate) oscillated back and forth in a regression channel, providing some short-term trades in the opposite direction, the prevailing upward trend remains in tact.

Figure 1: Australian Dollar Vs. U.S. Dollar

Source: Wordon Brothers

U.S. Dollar versus the Canadian Dollar
In the chart below, the Canadian dollar has strengthened against the U.S. dollar. Canada is also a commodities-producing country, with a lot of natural resources. In the case of the Australian dollar chart, there is an upward-sloping growth path as the demand for Australian dollars increases. Since the Australian currency is the base currency and the U.S. dollar is the quote currency, the chart shows a strong upward-trending and strengthening Australian dollar.

On the other hand, in the case of the Canadian dollar against the U.S. dollar, the U.S. dollar is the base currency while the Canadian dollar is the quote currency. Thus the chart shows the U.S. dollar sloping downward as it weakens against the Canadian dollar. (For related reading, see UsingBollinger Band "Bands" To Gauge Trends.)

Figure 2: U.S. Dollar Vs. Canadian Dollar

Source: Wordon Brothers

The conventional wisdom amongst traders is that "the trend is your friend." While this is good advice, we have to add the cautionary line that "the trend is your friend … until it ends."

Trends Vs. Ranges
Of course, the difficult questions to answer are whether we are in a trend at all, or just in a sideways-trading range, and where and when a trend will start and where and when it will end.

Let us first look at the question of where a trend could possibly start, and once started, where to take part in the action. To answer these questions, we need the help of some technical analysis. To keep our analysis as simple as possible, we'll create a chart that uses a weekly time frame and uses only two indicators.

The first indicator is a simple 20-period moving average calculated on the closing prices. However, to give us a little wiggle room we will also add an additional 20-period simple moving average, but this time calculated on the price "highs." Then we will add another 20-period simple moving average calculated on the price "lows." The result is a moving average channel that will reflect a dynamic price equilibrium. (For more, see Deadly Flaws In Major Market Indicators.)

We will use this channel to give us an idea of when prices are trending up and when prices are trending down. We will assume that if prices break below the channel there is a potential down trend, and if they break above the channel there is a potential uptrend.

Also notice that when a market trends in either direction, there is the tendency for prices to move away from the channel and then to return to the channel as volatility increases and decreases, respectively. With volatility, prices always tend to revert to the mean over a period of time. This reversion to the mean provides either buying or selling opportunities depending on the direction of the trend.

In addition to the moving averages, we also add a RSI set to a two-period, instead of the usual 14-period, with the plot guides set to 90 and 10 instead of the usual 70 and 30. (For more, see Find Forex Profit With The RSI Roller coaster.)

Figure 3: Daily EUR/USD

Source: Wordon Brothers

The chart shows some interesting opportunities. Look at the RSI and each time it reaches an extreme at the 90-plot guide it provides a sell opportunity while the trend is downward and prices are below the channel. Each time the RSI reaches the 90-plot guide, the price has also moved back to the channel, providing a new opportunity to sell in the direction of the trend.

Conversely, as the trend moves upward, prices revert to the channel at the same time as the RSI reaches the 10-plot guide, providing new buying opportunities.

Trading in the above manner means trading only in the direction of the trend each time it corrects, thus providing a new opportunity to participate.

Many traders will look to trade reversals. A reversal point is always where a trend starts or ends. To find these potential reversal points, we would look for price patterns (such as double or triple tops or bottoms), Fibonacci levels or trend lines. A reversal often occurs at a 127.2 or a 161.8 Fibonacci extension. Therefore, it is also useful to plot the Fibonacci lines on the weekly charts and then to watch what occurs on the daily chart as prices approach one of the Fib levels.

You will also discover that some trends are stronger than others. In fact, some trends become so exuberant that prices form a j-shaped or parabolic curve. On the next chart, we see an example of an irrational parabolic-shaped price curve of the World Silver Index. It is irrational because traders are pushing silver prices up, as the whole commodities complex is benefiting from strong fund flows into futures and ETFs without there being an equal and natural demand for the underlying product. This is a case of "musical chairs" and when the music stops the exit door will become very narrow and late arriving traders will get hurt.

The "spinning top" candlestick on the weekly silver chart should be a strong warning sign to traders that the trend could be ending. (For more, see Advanced Candlestick Patterns.)

Figure 4: Weekly Silver Index

Source: Wordon Brothers

In the case of the Canadian and Australian dollars (Figures 1 and 2), the curve shape follows a more normal upward slope than the silver price does. Traders should always be aware of the curve shapes, since parabolic curves indicate a "bubble" mentality developing in the market.

Stages of a Trend
Elliot Wave fans will observe that trending markets move in a five-step impulsive wave followed by a three-step ABC correction. Many investors prefer to count pivots, and they look for between seven and 11 advancing pivots, especially taking note of the pivot count as the price reaches a strong resistance level. (Learn how to set up a trading plan using this method. See Using Elliott Wave To Trade Forex Markets.)

We can't predict the future, but we can calculate the potential success of a trade by stacking various factors in an effort to tilt the odds in our favor. Since all speculation is based on odds, not certainties, we need to be mindful of risk and employ methods to manage the risk.

When placing a trade, it is essential to always place stops to limit losses, should the trade not go our way. Remember that the major market makers know where all the stops are sitting and could, in certain circumstances (especially in times of low liquidity) reach for the stops. Thus, our stops should be in a place where there is enough room to prevent them from being taken out prematurely.

To best manage a stop policy in trending markets, use "volatility stops." The well-known Parabolic SAR indicator can also be used to trail the market and take profits once the stop is hit. In the chart below (Figure 5), you can see how the 50-period three ATR trailing volatility stops trail prices and provide exit points if the trend suddenly reverses.

Figure 5: Daily XSLV Index - with Volatility Stops

Source: Wordon Brothers

The Bottom Line
It is best to trade with the trend but to be alert as to when a trend is exhausted and a correction or reversal of the trend is in order. By observing and listening to market sentiment, following news announcements and using technical analysis to help time entries and exits, you should be able to develop your own personal rule-based system that is both profitable and simple to execute.

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